Adipose-derived stromal cells (ASCs) present a great potential for tissue engineering, as they are capable of differentiating into osteogenic and adipogenic cell types, among others. In this study, we examined the role of Hedgehog signaling in the balance of osteogenic and adipogenic differentiation in mouse ASCs. Results showed that Hedgehog signaling increased during early osteogenic differentiation (Shh, Ptc1, and Gli1), but decreased during adipogenic differentiation. N-terminal Sonic Hedgehog (Shh-N) significantly increased in vitro osteogenic differentiation in mouse ASCs, by all markers examined (*p < 0.01). Concomitantly, Shh-N abrogated adipogenic differentiation, by all markers examined (*p < 0.01). Conversely, blockade of endogenous Hedgehog signaling, with the Hedgehog antagonist cyclopamine, enhanced adipogenesis at the expense of osteogenesis. We next translated these results to a mouse model of appendicular skeletal regeneration. Using quantitative real-time polymerase chain reaction and in situ hybridization, we found that skeletal injury (a monocortical 1 mm defect in the tibia) results in a localized increase in Hedgehog signaling. Moreover, grafting of ASCs treated with Shh-N resulted in significantly increased bone regeneration within the defect site. In conclusion, Hedgehog signaling enhances the osteogenic differentiation of mouse ASCs, at the expense of adipogenesis. These data suggest that Hedgehog signaling directs the lineage differentiation of mesodermal stem cells and represents a promising strategy for skeletal tissue regeneration.